While the majority of individual investors and traders focus on traditional investments such as stocks, ETFs, options and bonds, the fact remains that the forex market is by far the most active and liquid market in the world. As more and more individuals become aware of the forex market, and learn not only about how to trade currency pairs but also about the mechanics and capital requirements involved, their level of participation continues to grow. While the interest is genuine and the opportunities are real, traders new to this market must still decide just exactly how they will go about determining when to enter and exit individual trades.
SEE: Investopedia’s Forex Walkthrough
Finding the Trend
Most of the trading in the forex market takes place on a short-term basis. Large traders and institutions with high-powered computers and highly sophisticated trading algorithms account for much of the trading in forex pairs. And even for the small trader the lure of short-term trading is strong as it involves limiting the amount of time that capital is at risk. In fact, there is nothing wrong with trading on a short-term time frame. Nevertheless, one still has to decide whether to be bullish or bearish on a given pair before entering a trade. It is here where a longer-term, big picture snapshot can provide a useful roadmap.
Perhaps the oldest adage in all of trading is "the trend is your friend." And this adage has stood the test of time. While any number of short-term trading methods can be profitable, in most cases, it is easier to make money by trading in the direction of the major trend than it is to trade against it. As such, before considering a trade in any forex pair, one must attempt to objectively identify the current major trend of the market. From there, you can attempt to fine tune your actual entries and exits. The primary objective is to focus on long trades when the major trend is bullish, and on short trades when the major trend is bearish. Let's take a look at an example of one way to do this.
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Focusing on the Long Term
Figure 1 displays a simple monthly bar chart of the British pound/Japanese yen cross (GBP/JPY). As is the case with any tradable security -- there are times when this pair advances, times when it declines, and times when it trades in a range. Our primary function here is to establish a few simple methods for objectively deeming the major trend as "bullish", "bearish", or "neutral" at any given point in time. No method can be expected to be always right, but our primary purpose here is simply to determine the direction in which to trade (if any), NOT to identify specific entry and exit points.
|Figure 1: The British pound/Japanese yen currency cross (GBP/JPY)|
|Source: ProfitSource by HUBB|
Adding Trend Filter No.1
One of the simplest methods for trend-filtering is to apply a moving average to a data set. In Figure 2 you see the same bar chart, however, this time the 12-month exponential moving average has been added. There are advantages and disadvantages to using moving averages. The good news is that they allow a trader to quickly visualize the current trend by simply observing whether price action is above or below the moving average. The primary disadvantage to using moving averages is that a strict use of these to trigger entries and exits almost invariably involves whipsaw signals.
|Figure 2 - GBP/JPY with a 26-month exponential moving average|
|Source - ProfitSource by HUBB|
A rough interpretation of Figure 2 allows us to identify essentially five primary "trending periods" in the pair since 1992.
- From 1992 into late 1995 - primary trend DOWN
- From late 1995 until late 1998 - primary trend UP
- From late 1998 into early 2001 - primary trend DOWN
- From early 2001 until late 2007 (with a brief whipsaw in late 2003) - primary trend UP
- Since late 2007 - primary trend DOWN
Adding Trend Filter No.2
In an attempt to further refine our identification of the primary trend - and also to afford the opportunity to identify good times to make no trade at all (i.e., when two indicators disagree on the trend) - lets add another indicator into the mix. Figure 3 displays the same chart as that in Figure 2, however, now the MACD indicator is plotted below the bar chart.
The points in time when MACD changed from bearish to bullish are marked with upward green arrows. Conversely, points in time when MACD changed from bullish to bearish are marked with downward red arrows. Note that we have applied relatively long-term parameter values of 18, 37 and 9 for the MACD (the most common defaults are 12, 26 and 9). There are no "correct" values, and some experimentation might be needed market to market. Still, this setting fits in well with our desire to focus on the longer-term trend.
SEE: Spotting Trend Reversals With MACD
|Figure 3: GBP/JPY with 26-month exponential moving average and long-term MACD|
|Source: ProfitSource by HUBB|
At this point we would designate the "major trend" as "bullish", and would consider only long trades if:
a. GBP/JPY is above its 26-month exponential moving average, AND;
b. The latest signal from MACD was an "Up" green arrow.
Conversely, we would designate the "major trend" as "bearish", and would consider only short trades if:
c. GBP/JPY is below its 26-month exponential moving average, AND;
d. The latest signal from MACD was a "Down" red arrow.
Under any other circumstance, we would designate the "major trend" as "neutral" and would not trade the GBP/JPY pair. Namely, if:
e. GBP/JPY is above its 26-month exponential moving average but the attest MACD signal is a down red arrow, OR;
f. GBP/JPY is below its 26-month exponential moving average but the attest MACD signal is an up green arrow.
In case e or f above, we would sit out this particular currency pair.
One of the keys to trading success is developing the ability to spot opportunities and identify ways to take advantage of them. Clearly a great many opportunities are likely available at any given point in time among the various currency pairs traded on the forex. Trading in the direction of the major trend has long been one of the best methods for improving one's odds in the financial markets.
The specific methods described in this piece should be no means be considered the "be all, end all" of trend identification tools - far from it. In fact, they are presented merely as examples of ways to objectively identify and categorize the longer-term trend. Individual investors may find different and better ways to achieve this task across a cross-section of tradable markets. From there the next piece of the puzzle remains: deciding specifically when to enter of exit trades. Whatever method or methods one ultimately settles on, they will at least enjoy some peace of mind in knowing that they are trading with the primary trend of that particular market.
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